OREANDA-NEWS. Nigeria's banks are likely to face more challenges as interest rates continue to rise, says Fitch Ratings. The central bank's benchmark interest rates, which hovered around 6% from 2001 to 2011, have risen steeply. The latest increase came on 26 July, bringing rates up to 14% in a move to curb inflation and strengthen the naira.

Rising rates are likely to put additional pressure on banks' asset quality. Almost all lending is extended at floating rates and banks should be able to reprice their loans quite quickly but borrowers will face more difficulties in servicing their debts. Impaired loans are already high in the Nigerian banking sector, where average non-performing loan ratios reached 6.2% at end-March 2016, partly reflecting the impact of currency depreciation on businesses as well as higher oil-related problem loans at some banks.

We also expect loan growth (excluding foreign-exchange translation effects) to slow during 2H16 and into 2017. Banks have already tightened underwriting standards as economic conditions in the country worsen. GDP contracted by 0.4% year on year in 1Q16 and we forecast GDP growth to fall to 1.5% in 2016 (2015: growth of 2.7%).

With rising rates, excess liquidity in the banking sector is, in our opinion, likely to flow into additional holdings of higher-yielding government debt. Government securities represent about 16% of total Nigerian banking sector assets and 10-year senior bonds yield about 15.3%. Despite the rate rise, real interest rates remain negative when considering inflation, which reached 16.5% in June 2016. Nevertheless, for the domestic banks government bonds represent low-risk, low capital intensive investments. Lending, particularly in foreign currency, carries higher risks.

The rate increase will also lead to higher funding costs for the banks. This and the switch away from loans and into fixed-income government bonds are likely to squeeze Nigerian bank net interest margins. We also expect operating costs and loan impairment charges to rise but still expect Nigerian banks to remain profitable in 2016.

We downgraded Nigeria's sovereign rating to 'B+' in June and various bank ratings were downgraded in July. The challenging and volatile operating environment in Nigeria, as well as such factors as the banks' financial profiles, mean Nigerian bank standalone Viability Ratings (VR) are in the highly speculative 'b' category. Nigerian bank VRs are sensitive to a prolonged economic downturn and depressed oil prices, and to materially weaker asset quality.